Last month, the Schweizerische Nationalbank (SNB), the nation’s central bank recorded some large ‘book’ losses after it had abandoned its attempt to stop the Swiss franc (CHF) from appreciating against the euro. It started trying … as a way of protecting its manufacturing sector but abandoned the strategy on January 15, 2015. It had been buying euro in large quantities with francs and on April 30, 2015 the SNB released the – Interim results of the Swiss National Bank as at 31 March 2015 – which showed that its first-quarter 2015 losses were 30 billion CHF or around 29 billion euros. They lost CHF 29.3 billion on its “foreign currency positions” and CHF 1 billion on its gold holdings. This has raised the question, once again, whether central bank losses matter. The answer is always that they do not matter at all given the central bank can never become illiquid as it issues the currency (under some arrangement or another). So the commentators who whip up a lather about impending doom arising from central bank bankruptcies are to be ignored. But central bank officials also publicly express concern about their capital holdings. Why would they introduce that concern into the public domain when they know full well that they cannot go broke. The answer is that they are politicians themselves except they evade democratic scrutiny and election.
In its April 30, 2015 Press Release (cited in the introduction), the SNB say that:
On 15 January 2015, the SNB decided to discontinue the minimum exchange rate of CHF 1.20 per euro with immediate effect. This led to an appreciation of the Swiss franc and, as a result, to exchange rate-related losses on all investment currencies. For the first quarter of 2015, these amounted to a total of CHF 41.1 billion.
The CHF 41.1 billion was offset somewhat (down to CHF 29.3 billion) by interest and dividend income, and price gains on bond and equity holdings.
In September 6, 2011, the SNB introduced the exchange-rate peg because it believed the CHF was overvalued against the currencies of its trading partners.
I wrote about the decision to abandon the peg in this blog – SNB decision tells us that the crisis is entering a new phase
The January 15, 2015 – Decision – by the SNB to both break the peg of the Swiss franc to the euro and cut its interest rate on sight deposits to -0.75 per cent signalled the surrender by that nation to the reality surrounding its borders.
The interest rate decision was required after it decided to scrap the exchange rate peg, given that it didn’t want a credit crunch killing the domestic economy.
This is what happened (using daily data available from the – SNB). The data goes up to yesterday (May 27, 2015).
This is a longer-term view (using – Monthly SNB data) and an appreciation is a fall in the graph (given the way the data is arranged).
The arrow shows the appreciation that particularly against the USD but also the yen and the euro, which led the SNB to impose the peg on September 6, 2011. At the time, it was clearly a decision aimed to protect the export sector, which is the largest as a percentage of GDP in the world (around 73 per cent, compared say to South Korea (54 per cent), Germany (46 per cent), China (27 per cent), Japan (16 per cent) and the US (14 per cent).
At the time, the SNB released a press statement – Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro – which said it was “prepared to buy foreign currency in unlimited quantities” to reduce the value of the CHF.
In other words, it acknowledged its currency sovereignty and its capacity to create “unlimited quantities” of it to pursue its stated goals.
As the graphs show, the decision clearly stabilised the CHF against the euro and the US dollar.
Of course, the operations associated with the strategy increased the SNB’s holdings of foreign currency reserves (particularly the euro). The arrow marks the announcement in September 2011. You can get the data – HERE.
Some might think that the SNB balance sheet looks very similar to that of the US Federal Reserve, or that of the Bank of Japan, or the Bank of England for that matter.
The answer is that the SNB wasn’t engaged in Quantitative Easing, which we understand to be the purchase of sovereign bonds in exchange for bank reserves. Rather, the SNB was buying the currencies of other nations in exchange for francs and so the valuation of its reserve holdings are highly exposed to movements in those currencies.
The first-quarter 2015 SNB results now reveal that the massive holdings of foreign currency reserves, particularly euros has resulted in ‘book’ or ‘paper’ losses on their foreign currency holdings (as the exchange rate appreciated).
One argument at the time (January 2015) was that the SNB abandoned the peg to minimise these losses given that the ECB was about to embark on a massive QE exercise itself, which would drive the euro down in value against the CHF.
At the time I did not support that interpretation. The SNB has no need to be concerned about these paper losses given it is the currency-issuer. Unlike a private bank, the SNB could operate with permanent negative capital.
Please read my blog – The ECB cannot go broke – get over it – for more discussion on this principle.
While the central bank officials would hardly acknowledge the logic in that blog in public, they know it to be true and would hardly have made the decision on the basis of the myth that they can go broke.
At the time, I guessed that the SNB realised that with such a conservative fiscal position being run by the Swiss government and policy austerity surrounding its borders that deflation is inevitable and that they may as well return to a more normalised position (historically) now before the ECB changes its strategy.
I continue to hold that view.
There was a recent Op Ed article in Money and Banking (May 26, 2015) – Do central banks need capital? – which bears on the topic of SNB losses.
They use the SNB case study to explain why central banker governors posit public positions that are in total contradiction to the position espoused by “monetary economists”, the majority of which when asked “whether we should care if a central bank’s capital level falls below zero (even for an extended period of time) … will say no”.
The answer of the “central bank governors … in nearly every case will be yes”.
The authors (one a former central banker and BIS economist) state that:
The economists correctly argue that central banks are fundamentally different from commercial banks, so they can go about their business even if they have negative net worth. However, central bankers know instinctively that the effectiveness of policy depends critically on their credibility. They worry that a shortfall of capital would threaten their independence, which is the foundation of that credibility.
In other words, the public concern for central bank losses is about politics and has nothing intrinsically to do with financial or economic concerns.
That is an important point to understand. The former is contestable while the latter is just the fact (in this case) – central banks can never go broke and therefore what capital stock it holds is moot.
The authors explain why the central bank can never go broke. The two most important reasons are that:
1. “a central bank can issue liabilities regardless of its net worth. It can never be illiquid”. That is categorical and means that all the financial pundits that have been predicting the US Federal Reserve or the Bank of Japan or England would face bankruptcy are not worth reading. They do not understand the topic they are discussing.
2. Importantly, “because it is really part of the government, it is reasonable to consolidate the central bank’s balance sheet with the government’s broader balance sheet. From this standpoint, it is of little import whether a single part of the larger balance sheet exhibits positive or negative net worth.”
Please read my 2010 blogs – The consolidated government – treasury and central bank and Central bank independence – another faux agenda – for more discussion on this point.
So why would central bank governors give the impression that they need certain capital to asset ratios maintained.
The authors note that the SNB losses on its foreign exchange dealings in the first quarter ammount to “about 6½% of Swiss GDP”, which has reduced the bank’s “capital and provisions below 10% of assets”.
Further, noting the balance sheet graph (foreign reserve assets) above, the SNBs “foreign exchange risk remains enormous: a further decline in the value of foreign currency instruments of 11% would wipe out the SNB’s capital.”
And as a monetary economist I just say – so what.
The point of the Op Ed is to explain that the SNB shifted policy in January 2015 because the SNB management had:
… political concerns about the impact of even larger future portfolio losses … as any central bank governor will tell you, the real threat arising from episodes in which there are significant losses is political, not economic.
Which raises the question of what politics are central bank governors engaged in? It is clear that the idea that central banks are independent from the political process is false. In most cases, the elected government officials (the politicians) appoint the senior officials at the central bank.
In some cases, the government of the day can overrule the monetary policy decision from the central bank board if they feel it is detrimental to their own political agenda.
One could hardly say that the senior officials at the Bank of Japan are adopting a cautious line for fear of political intervention.
The Bank of Japan pioneered quantitative easing and its balance sheet is massively exposed to losses (for example, on the value of the public bonds it holds). But if it is worried about that ‘loss exposure’ then its current behaviour would hardly suggest that.
So what are these “political constraints” on central bank independence? The authors note that one problem might arise from a failure of the central bank to remit profits to the relevant treasury.
They use the US example:
… as the Fed raises interest rates in coming years, remittances almost certainly will decline … while the rising payments on reserves likely will go mostly to large U.S. banks and to foreign banks … This mix could easily fuel a populist assault on Fed independence in Congress …
It is true that politicians occasionally come up with ridiculous ideas to have more direct control over monetary policy decisions.
Changing a board or sacking a governor, much less overruling an interest rate decision would be a rather dramatic act of an elected government. There is clearly subtle pressure on central banks but not much overt intervention.
The – Federal Reserve Transparency Act of 2015 – in the US is a case in point.
The usual case for independence is that central banks can adopt policies that are beyond the political cycle which then provide stronger discipline on inflationary expectations. Allegedly, politicians can be easily swayed by increases in unemployment to introduce expansionary policies and not worry about the longer-term inflationary consequences because their political term is short.
There is a big literature on the so-called time inconsistency problem in economics which seeks to analyse the problems of short-term thinking against longer-term threats.
Mostly, the literature is just a sop to undermine the case for fiscal activism and democratic oversight.
The research literature also does not unambiguously find that more central bank independence (of course there are huge measurement issues) brings lower inflation.
The most comprehensive and rigorous work on the impact of inflation targeting is the 2003 study by Ball and Sheridan who aimed to measure the effects of inflation targeting on macroeconomic performance in 20 OECD economies, of which seven adopted inflation targeting in the 1990s.
They used special econometric techniques (which are widely accepted) to compare nations that had adopted targeting to those that had not. Overall, Ball and Sheridan found that inflation targeting does not deliver superior economic outcomes (mean inflation, inflation variability, real output variability, long-term interest rates).
One of the claims made for inflation targeting is that central bank independence and the alleged credibility bonus that this brings should encourage faster adjustment of inflationary expectations to the policy announcements. Ball and Sheridan found that there is no evidence that targeting affects inflation behaviour in this regard.
I also considered these issues in this blog – Central bank independence – another faux agenda.
An Modern Monetary Theory (MMT) insight is that there is little to be gained from artificially separating the two arms of macroeconomic policy making (central bank and treasury).
The two have to work together on a daily basis in reality (the bank has to know what the treasury is doing with respect to deficits so it can manage liquidity and defends its interest rate target).
Further, policy should have strong democratic oversight. I cannot vote to get rid of the RBA governor and the board even if they are running monetary policy that damages the economy (many times) because they are obsessed with the inflation bogey.
It is clear that the SNB losses are largely irrelevant from an economic perspective. The fact that several central banks are holding Greek government debt also means that they could just click a few keyboard strokes and write them down to zero without no negative consequences at all.
This would give the Greek nation a massive boost, along the lines of the debt forgiveness that was given to Germany in the post Second World War period.
The losses of the write offs would have zero impact on the ability of the banks to conduct monetary policy and maintain financial stability.
So given the gains are so large (for Greece) and the losses of no consequence why wouldn’t they do it.
But then politics should be an arena of contest where we vote. So if central bankers want to play into this arena they should be subject to democrative oversight, which goes beyond appearing on a regular basis before the elected parliament.
The reality is that there is nothing to gain for the citizenry from having central banks artificially separated from the elected government.
There is a lot to be gained for the managers etc who can evade scrutiny and accountability while enjoying high salaries, lengthy and secure tenures and get to bully depressed nations like Greece around!
That is enough for today!